The evidence from several studies suggests growing inequality among the Indian states in the past three decades, with the rate increasing in the 1990s.
Differences in infrastructure and institutions that seem to explain interstate differences have been persistent, and neither Finance Commission transfers, Planning Commission transfers, nor central ministry transfers have made a substantial dent in regional inequalities in India.
Growing regional inequality is a concern, particularly because it can threaten political stability. Liberalization has meant a reduction in central government control of industrial investment and other aspects of regional economic policy, leaving the intergovernmental transfer system in the spotlight.
What are possible reforms that can be made in the transfer system, if growing regional disparities are a concern, and can they be politically feasible? One example of the political feasibility in the process of institutional reform comes from the case of tax-sharing arrangements. The Constitution specified certain categories of centrally collected taxes that were to be shared with the states, according to criteria to be determined by the Finance Commission.
In particular, personal income taxes were a major component of tax transfers from the center to the states, which received 87.5 percent of such tax revenues. However, income tax surcharges were kept entirely by the center.
Academic commentators suggested that there were obvious incentive problems with such arrangements, and the Tenth Finance Commission recommended alternative arrangements whereby a proportion of overall central tax revenues would be devolved to the states.
This required bargaining and agreement among the center and the states, as well as a constitutional amendment, but this was all accomplished by 2000.
There is a case for the Finance Commission and Planning Commission overhauling their transfer formulae completely, to achieve greater simplicity. Such reforms would not solve problems of increasing inter-state inequalities, since the variation in SDP per capita is far greater than the level of per capita transfers. However, they would make the formal transfer system clearer and simpler, and make it easier to understand its objectives and its impacts.
Removing a significant portion of center-state transfers outside the political economy arena, clearly targeting them toward horizontal equity objectives, and doing so in a manner that does not create perverse incentives for recipients, is feasible and desirable in it this approach is contrary to the idea of using the intergovernmental transfer system to provide very refined or targeted incentives to meet general fiscal balance goals, but we would argue that is most appropriate for the bulk of intergovernmental transfers.